Why is Supply and Demand so Confusing?

Maybe you don’t find it confusing, but I do. It all started a few years ago when we noticed that we had a “trick question” on our placement exam at Bentley. The question asked what would happen to the demand for tea if there was a health scare regarding coffee. Obviously coffee and tea are substitutes. So if the health scare reduces the price of coffee then the demand for tea will . . . well, let’s think about it a bit more.

Then a few years later I noticed the following statement in chapter 4 of Mankiw’s intro text:

“Suppose that the price of frozen yogurt falls. The law of demand says that you will buy more frozen yogurt. At the same time you will probably buy less ice cream.”

Well at least that clears up the coffee/tea example. A health scare will reduce the price of coffee. Since coffee and tea are substitutes, if the price of coffee falls you will buy less tea.

Or will you? Doesn’t Mankiw’s yogurt example also imply that “the law of supply says you will sell less yogurt” when the price falls. And since the “law of logic” says that the number of units sold equal the number of units bought, we’ve got a problem here somewhere.

An article in The New York Times described a successful marketing campaign by the French champagne industry. The article noted that “many executives felt giddy about the stratospheric champagne prices. But they also feared that sharp price increases would cause demand to decline, which would then cause prices to plunge.” What mistake are the executives making in their analysis of the situation?”

I thought the answer was that the marketing campaign had caused the demand to increase, and that caused both price and quantity to increase. But that can’t be right because Mankiw already told us that when the price goes up people will buy less yogurt—surely the same must be true of champagne? So there seems to be a conflict.

That was the 3rd edition. Then the 4th edition came out, and question 12 mysteriously disappeared, like a missing face from a Stalin-era group portrait. All the other questions were still there. I emailed Mankiw to ask him why my favorite question was removed, and he indicated that with each new edition changes were made based on feedback from professors who used the book.

The yogurt example is still there in the 4th edition. Perhaps most professors agreed that a higher price of yogurt does reduce consumption, but thought that an accurate treatment of supply and demand such as question 12 would be “too confusing.”

That’s when I started notice that I was in the minority. Many economists seem to like to do what I call “reasoning from a price change.” It goes like this:

1. If interest rates fall sharply we can expect investment to . . .

2. If the price of oil falls then consumers will . . .

3. If the dollar depreciates then our imports/exports/trade balance will . . .

Let’s take these one at a time. This year interest rates have fallen to low levels, and investment has plummeted. So lower interest rates must reduce investment. The price of oil has plunged, and oil consumption is also down. So low oil prices would seem to reduce oil consumption. Now at this point you might be getting fidgety. “Wait, you’re not holding other things equal. Something else changed.”

But that’s not really the problem. Of course something else changed, how else could the price/interest rate/exchange rate have changed in the first place! There is nothing “tricky” about the examples I just provided, they are straight-forward applications of supply and demand. Draw a supply and demand curve. Then shift demand to the left. You will clearly see that at a lower price consumption will drop.

So what do we know about prices? We know that if the price falls because supply increases, then consumption will increase, and if the price fell because demand fell, then consumption will decrease. In other words we know that if the price (or interest rate or exchange rate) changes, we can predict with 50% confidence that quantity will increase, and 50% confidence that quantity will decrease. So that’s progress, I guess.

Recently I read that the current low energy prices are actually a “bad thing,” because they will discourage consumers form conserving. I found this interesting, as I think the current low prices are a bad thing because they reflect consumers conserving energy. Why are they “conserving” energy? Because they are out of work.

Often I read that the Fed made a huge mistake cutting interest rates to 1% in 2003, because it blew up a housing bubble. I thought interest rates fell in 2003 because investment fell.

I notice that people really like to pontificate about exchange rates. I really don’t know much about open economy macro, but I always wonder what people mean when they talk about the implications of a falling dollar. Why would the dollar fall in the first place? More sophisticated pundits will talk about a scenario where foreigners suddenly don’t want to hold American dollars any more. So now we finally have a root cause, and we can see what happens next. But why do foreigners not want to hold dollars anymore? Does it mean that they no longer want to run trade surpluses with the US? And if so, why not? Do they want to save less, or invest more? And how will their preference for balanced trade affect us? All we really know is that our trade deficit will disappear. But what does that mean for the US economy? More exports? Or less imports? Suppose the Fed is targeting NGDP when this collapse in confidence in the dollar occurs? What then? Here is the Sumner Rule, derived from 54 years of watching predictions fail to come true:

If over several business cycles people keep saying a trend is unsustainable, it is sustainable. Or at least you will not live long enough to see it reversed. It may be reversed some day, but since you will not live long enough to see it reversed, it’s not worth thinking about.

What sort of unsustainable trends am I thinking about? How about Asians lending money to Aussies and Americans? Or how about health care costs rising as a share of GDP? By the way, on this point it might be easier to think in terms of “non-health care costs.” Suppose the non-health share of GDP falls in half every 500 years. Then total spending on non-health would still be able to rise as long as we had any kind of decent RGDP growth rate. Can’t happen forever? Don’t bet on it.

Lessons for teaching economics

Is it possible that economics students don’t learn anything when we teach them supply and demand? It seems to me that there are basically two things we’d like our students to know about S&D (before we get into applications like price controls and taxes):

1. The impact of a supply or demand shift.

2. How to draw inferences from changes in prices and quantity.

I teach at an institution that is well above average, and here is what I have found. Almost every single student comes into EC101 knowing the impact of supply and demand shocks. Tell them a frost hits the Florida orange crop, and they can explain what happens to the price of oranges. Tell them millions of Chinese start buying cars and they can tell you what happens to the price of oil.

I also find that almost no student comes into my class knowing how to interpret price and quantity data. And what is worse, then leave the course equally ignorant. I often ask the following question to upper level econ or MBA students who have already taken principles:

Question: A survey shows that on average 100 people go to the movies when the price is $6 and 300 people go when the price is $9. Does this violate the laws of supply and demand?

Very, very few can answer this question, especially if you ask for an explanation. Even worse, I think there is a perception that there is something ‘tricky’ about this question, something unfair. In fact, it is as easy a question as you could imagine. It’s basic S&D. It’s merely asking students what happens when the demand for movies shifts. I cannot imagine a less tricky question, or a more straightforward application of the laws of supply and demand. In the evening hours the demand for movies shifts right. Price rises. Quantity supplied responds. What’s so hard about that? And yet almost no student can get it right. Our students enter EC101 knowing one of the two things they need to know about S&D, and they leave knowing one of the two things they need to know about S&D. Maybe instead of having them memorize mind-numbing lists of “5 factors that shift supply,” and “5 factors that shift demand,” we should just tell them to read something that will explain what economics is all about, something that portrays economists as detectives trying to solve the identification problem, something like Freakonomics.

If there are any other economics instructors out there I’d like to know what you think. I really don’t think we need to teach students what happens when frost hits the Florida orange crop. Perhaps we should just put supply and demand into an appendix and tell them to study it if they need to. Instead devote 100% of chapter 4 to the identification problem. Leave all the technical stuff for students majoring in economics to take in their intermediate level courses. Or maybe the identification problem is too hard, and we should simply forget about teaching supply and demand. Devote the whole course to opportunity costs, incentives, marginal analysis, etc.

I’m open to suggestions. But when I read the newspaper, even the elite newspapers like the NYT, FT, WSJ, etc, I feel like something is wrong. What they are doing is about as closely related to economics as astrology is to astronomy. Talking about the implications of price/interest rate/exchange rate changes is about as useful as talking about the implications of Saturn being in Aquarius.

PS. In case Greg Mankiw is reading: The fact that I use your book shows that I think it is the best one out there.

PSS. In case Tyler Cowen is reading: Ignore the previous PS, I haven’t had a chance to check out your (and Alex’s) book yet.

Scott Sumner has taught economics at Bentley University for the past 27 years.

He earned a BA in economics at Wisconsin and a PhD at University of Chicago.

Professor Sumner's current research topics include monetary policy targets and the Great Depression. His areas of interest are macroeconomics, monetary theory and policy, and history of economic thought.

Professor Sumner has published articles in the Journal of Political Economy, the Journal of Money, Credit and Banking, and the Bulletin of Economic Research.